Deluxe Chicken (DC) was established in 1989 by Sebastian Bony. It sells delicious rotisserie-cooked chicken with fresh vegetables and other side dishes through its own stores and franchisee stores, just like Kentucky Fried Chicken (KFC). According to Seb, DC’s strategy is to be “a home meal replacement” in the New England and Mid-Atlantic regions. DC went through an impressive expansion. At the end of 1991, the firm operated only 34 stores, with no franchisee stores. But by the end of 1994, the total of stores (company-owned stores and franchise stores) had increased to 534 (491 were franchise stores). It was estimated that DC’s franchise store can easily break even if its weekly average revenue per store is higher than $23,000. According to Reuters, its stock price had risen steadily from $8 in November 1993 to $23 in March 1997.

DC’s auditor is a prestigious Big-8 accounting firm, Firehouse Young LLP. The 1994 and 1995 fiscal year financial statements below were all audited numbers, but the 1996 numbers were unaudited.

DC’s excellent performance also impressed the Street. Stock analyst Mike Foster of Silverman Sterling forecasted that DC’s EPS would grow at an annual rate of around 35% between 1997 and 2001 and gave a “strong-buy” rating. It was rumored that the wealth management division of Mohan Stanley took a passive 3% stake in this firm. Many hedge funds followed the rumor and added DC’s shares to their portfolios.

Below is some info from footnotes for your reference:

1. Principles of Consolidation. The consolidated financial statements include the accounts of the Company and its subsidiaries.
2. Revenue Recognition. Revenue from Company stores is recognized when food is sold. Royalties are recognized when related franchise store revenue is generated. It is 5% of the franchise revenue. Initial franchise fees and area development fees are recognized as DC’s revenue when the franchised store opens. Franchisee store also pays 5.75% of its revenue for system-wide marketing use.
3. Franchise store performance is not included in the consolidated financial statements since DC has no equity investment larger than 50% in any store.
4. Area developers are large regional franchises which focus on major U.S. metropolitan markets. The initial investment consists of 25% equity (contributed by independent business people) and 75% loan made from Deluxe Chickens. Area developers have no other sources for investment. DC believes that it is difficult for small franchises to get bank loans, therefore, DC always loan the money to support those area developers. Loan is recorded at historical cost. The average interest rate is around 8.2% in 1996.

You are a senior auditor at Firehouse Young LLP, assigned to audit DC’s 1996 financial statements in early 1997. John is the manager in charge and Kelvin Collins, a straight-A graduate from CSU South hill, is your junior. Below is a conversation between you (Y) and Kelvin (K).

Y: DC is not a difficult account, but the audit fee is never fat. So watch out when filling in timesheets. BTW, have you ever tried AP (analytical procedures) by now?

K: Got it, AP not done yet. But I had a quick scan of the numbers and compared net income and OCF in the last 3 years. Net income looks healthy as it is well-supported by operating cash flow. Look at the numbers below, NI/OCF ratio varies between 0.45 and 0.60. No negative OCF and no “kiss of death” in 1995 and 1996. Not a tough audit this year.

Required: 

Turn your clock back to February 1997. As a senior auditor, perform the analytical procedures and then write a memo to your manager. In your memo, you must highlight those accounts that might be subject to material misstatements and support your conclusions with solid evidence/argument.